Fed's Stock Levitation Failing

The US stock markets just suffered an extraordinary plunge, shocking traders
out of their complacency psychosis. This cast the foundational premise behind
recent years' incredible stock-market levitation into serious doubt. Traders
are finally starting to question whether central banks can indeed manipulate
stock markets higher indefinitely. Any wavering in this faith has very bearish
implications for stock prices.

Less than two weeks ago, the US's flagship S&P 500 stock index (SPX) was
up above 2100. It finished August's middle trading day just 1.3% below the
latest record highs from late May. At the time, the Wall Street analysts were
overwhelmingly bullish and saw nothing but clear sailing ahead. Predictions
for the SPX ending this year above 2250 were ubiquitous, and retail investors
were urged to aggressively buy stocks.

But warning signs abounded on fundamental, technical, and sentimental fronts
as I've discussed in our newsletters extensively. The US stock markets were radically
overvalued relative to historical norms in trailing-twelve-month price-to-earnings-ratio
terms. As the SPX left July, its 500 elite components had a simple-average
trailing P/E of 25.6x! That was nearing 28x bubble territory, far above
the 14x historical
average.

Stock-market technicals were incredibly overextended too. By the SPX's peak
in late May, this massive broad-market index had powered higher for 3.6
years without any correction-magnitude selloffs. In normal bull markets,
these 10%+ selloffs happen about once a year on average. They are healthy and
necessary to rebalance sentiment. The longer since the last major selloff,
the greater the odds for the next one.

And without normal corrections to bleed away excessive greed periodically,
it was really getting extreme. The VIX S&P 500 implied-volatility index
has long been the definitive fear gauge. And it had spent the month between
mid-July and mid-August averaging just 12.9 on close. That showed American
stock traders feared nothing, they were exceptionally complacent and full of
hubris. Mounting selloff risks were ignored.

Yet these very conditions were perfect for spawning a selloff, as all
students of the markets know. The only reason it took so long to arrive was
traders' fanatical faith in central banks to keep acting to boost stock prices.
Traders believe central-bank easing has the power to eradicate normal stock-market
cycles. While market history shatters this myth of central-bank omnipotency,
it is universally assumed today.

The US Federal Reserve birthed and then carefully nurtured this notion. Back
in December 2008 the Fed implemented its zero-interest-rate policy in
response to that year's once-in-a-century stock panic. It was promised to be
a temporary measure. After that the Fed started conjuring new dollars out of
thin air to buy trillions of dollars of bonds, outright
debt monetization pleasantly euphemized as quantitative easing.

While the first and second QE campaigns had preset sizes and end dates determined
at launch, the Fed radically shifted its modus operandi for the third campaign.
Spun up to full speed in early 2013, QE3 was open-ended. The Fed deftly
used this ambiguity to entice and badger capital into stocks. Whenever the
stock markets threatened to fall, Fed officials rushed to hint that they could
ramp QE3 to arrest the selling.

The result was the extraordinary stock-market levitation since early
2013. With the Federal Reserve's implicit promises to backstop stocks,
traders flooded in with reckless abandon. Every minor selloff was quickly met
with aggressive buy-the-dip purchases, usually on some strategically-timed
comment by a top Fed official. Near every major SPX low, Fed officials goosed
stocks by arguing QE3 could be expanded.

So traders ignored the entire highly-cyclical history of the stock markets
to keep on bidding them higher in recent years. Without any material selloffs
thanks to Fed jawboning, complacency and greed quickly ballooned to dangerous
extremes. Leading the way were countless hundreds of billions of dollars in corporate
stock buybacks, largely financed through cheap borrowing courtesy of the
Fed's zero-bound rates.

But something had to give, as the stock markets are
forever cyclical. Not even the central banks' printing presses can eradicate
the greed and fear in traders' hearts, and those emotions are what ultimately
drive market cycles. Traders wax too greedy and bid stock prices way above
fundamentally-righteous levels, leading to subsequent major selloffs. Then
traders fearfully run for the exits, leaving stocks too cheap.

Earlier this summer, the failure of China's popular speculative mania should
have irreparably damaged the omnipotent-central-bank myth. China's central
bank had engineered an extreme stock-market rally through exquisitely-timed
rate cuts. China's flagship Shanghai Composite stock index had soared an astounding
110.8% higher in less than 7 months by early June! Most traders thought that
rally was unassailable.

There is no government in the whole world with more power over its local economy
than China's. So its government-nurtured stock-market bubble was the ultimate
test of the all-powerful-central-bank thesis. And despite extreme and unprecedented
efforts to manipulate stocks higher, the Shanghai Composite still plummeted
by 32.1% in less than a month as greed turned to fear when that stock
bubble popped.

Since history has proven countless times that central banks can only temporarily
delay stock-market cycles, never eliminate them, we bet against that
Chinese stock bubble before it popped. We bought and recommended puts trades
on the leading Chinese-stock ETF, and our subscribers soon realized profits
averaging +137% in just several months. Central banks can't manipulate stock
prices for long.

Yet amazingly, the Fed-deluded American traders ignored the sobering example
of China's gross failure of central-planned stock markets. They still clung
to their zealous faith in the American central bank's magical ability to levitate
stock markets indefinitely. This was foolish, as I've argued many times in
the past couple years. Artificially delaying selloffs makes markets feel less
risky, but greatly amplifies risks in reality.

My favorite analogy of the risks of central-bank stock-market manipulation
is wildfires. However noble governments' intentions, when they send
firefighters to quickly extinguish small wildfires that just lets underbrush
flourish unchecked. Sooner or later there is so much dry fuel laying around
that some small wildfire quickly mushrooms into a hellfire conflagration. Suppressing
small fires guarantees far bigger ones later!

The same is true of suppressing normal and healthy stock-market selloffs.
Those firefighting efforts by the central banks enable dangerous levels of
sentimental and technical underbrush to choke off the stock markets. Then it's
only a matter of time until the right spark arrives, and the whole fuel-rich
mess flashes into intense and uncontrollable flames. These dwarf central-bank
printing presses' ability to help.

The Fed's extreme selloff-suppression efforts fueled one of the most extraordinary
stock-market runs in history in recent years. While no one could know in advance
when the catalyst would arrive to ignite all that epic complacency, it emerged
out of the blue with no warning just a week ago. And even the initial resulting
devastation is incredible, as this Fed-levitation-era chart of the VIX and
leading SPY S&P 500 ETF shows.

While the Fed formally launched QE3 in September 2012 just in time to sway
the national elections in Democrats' favor, it didn't ramp to full steam
to include direct monetizations of US Treasuries until a few months later
in December. That's when the surreal QE3-stock-market era started. Between
late December 2012 and May 2015, that dominant SPY SPDR S&P 500 ETF tracking
that index soared 52.5%!

But that extreme straight-up stock-market advance was always unnatural. It
improbably began late in a maturing cyclical bull when stock prices were
already high and overvalued. And it continued powering higher with nothing
approaching a correction. Every time the stock markets started to dip, Fed
officials would quickly step up to the microphones to assure traders they were
ready to ease more if necessary.

Most of those proto-selloffs were
artificially stunted before they even hit the 4% pullback threshold. The only
one that even threatened a correction-magnitude 10%+ came in October 2014.
That heavy selling started accelerated on poor European economic data, and
SPY ultimately dropped 7.7% in 20 trading days. But that selloff ended on Fed
jawboning and a parallel surprise European Central Bank easing.

But even in that only significant selling episode of the Fed's entire stock-market
levitation, it never got bad enough to generate enough fear to eradicate excessive
greed. The highest VIX close in that whole episode was just 25.5. While that's
certainly elevated, it was nowhere near high enough to indicate serious fear.
So the extreme complacency and hubris of 2013 and 2014 spilled into this year
as well.

But the Fed-goosed stock markets were running out of steam as tinder-dry sentiment
underbrush grew wild. By early March the SPX was up near 2120, levels that
would still barely be exceeded by late May. Not even uber-dove Janet Yellen's
most-easy Federal Reserve ever seen could manage to stoke new buying. The writing
was on the wall, and any
shift in Fed policy was a major risk as I warned in mid-June.

It hadn't just been the 2.4 years of the Fed's SPX levitation by its latest
record highs in late May where the US stock markets hadn't experienced a normal
correction, but a whopping 3.6 years! The last one came in summer 2011 just
after the Fed ended its earlier QE2 debt-monetization campaign. And not surprisingly
in stock markets at price levels that are almost entirely a Fed-conjured fiction,
the Fed dispelled it.

On Wednesday August 19th, the minutes from the Fed's latest Federal Open Market
Committee meeting held at the end of July were due out. They were super-important
because they offered the last glimpse into Fed officials' thought processes
and internal debates before the FOMC's next meeting. It is coming on September
17th, and has long been assumed to be the highest-probability target for
rate hikes to start.

This is a huge deal since the Fed hasn't raised interest rates a single time in
9.2 years, since June 2006. And the Fed has never, ever attempted to
tighten after a prolonged ZIRP episode. So the coming rate hikes are wildly
unprecedented. The release of those FOMC minutes was botched when Bloomberg
accidentally broke an embargo nearly a half-hour early. And stock traders
didn't like what they saw.

There was nothing in those latest FOMC minutes to dispel the growing fears
that the Fed was ready to start its next rate-hike cycle at its next mid-September
meeting. Since the entire stock-market levitation since early 2013 was fueled
by epic Fed easing and the resulting extreme corporate stock buybacks, this
cast serious doubts on this extraordinary stock rally's longevity. So stock
traders started to drift to the exits.

The SPX retreated 0.8% that FOMC-minutes day last Wednesday, which was no
big deal. But the Fed worries really intensified on Thursday. Traders couldn't
figure out if they were more worried about the Fed hiking rates in September,
or not hiking rates in September. The latter scenario would mean the US central
bankers still perceive the US economy as too weak to withstand even a trivial
quarter-point rate hike.

So the stock selling escalated, pummeling the SPX down 2.1% to close at its
lows. This shattered its 200dma, which had been major support for the
Fed's entire SPX levitation as the SPY chart above shows. It also dragged the
SPX to a new post-topping low of 2036. That formally forced the US stock markets
into pullback territory with a 4.5% drop since late May. But the selling pressure
sure wasn't over yet.

Complacency had become so extreme that there was choking underbrush for that
wildfire to feed on. Last Friday, some weak Chinese factory data amplified
long-festering fears of a global slowdown. So American stock traders' selling
started getting frantic, pummeling the SPX 3.2% lower. That was its biggest
down day in 3.8 years, since November 2011. The SPX's total pullback
had ballooned to 7.5%.

This not only rivaled that previous-largest-of-Fed-levitation October 2014
pullback, but the VIX closing at 28.0 was the highest levels of fear seen since
December 2011. In other words, American stock traders had not been so scared
for the Fed's entire SPX levitation since early 2013! The Fed's endless selloff-suppression
efforts had finally failed, the wildfire of cascading selling was starting
to rage out of control.

Coddled stock traders aren't used to serious selloffs, and had a whole weekend
to stew over the SPX being back at levels first seen in July 2014. An entire
year's progress had been erased in just two trading days! So they came
back this past Monday morning ready to sell and get the heck out of Dodge.
An exacerbating factor emerged in China, the further failure of the omnipotent-central-bank
thesis.

Since China's stock markets had collapsed back down near their initial post-bubble
lows of early July, local traders expected the People's Bank of China to again
ride to the rescue over the weekend with a rate cut. But the PBoC failed
to act, so the Shanghai Composite plummeted an astounding 8.5% on Monday!
It was down a staggering 37.9% in just 10 weeks. This heavy selling soon spilled
into Europe.

Germany's flagship DAX stock index plummeted 4.7% that day, and France's CAC
40 was even worse with a 5.4% loss. So SPX futures just collapsed as the globe
spun back to the US, falling over 100 points. The financial media was calling
it "Black Monday" that morning, although this selloff was nothing like October
1987's real Black Monday that saw the SPX crash 20.5% in a single trading day.

Still the SPX plunged another 3.9% on Monday, taking its total post-topping
selloff to 11.2% which was well into 10% correction territory. After a 3.6-year
Fed-induced delay, the long-overdue correction has finally arrived.
The heavy selling continued on Tuesday, where early-day short-covering gains
rolled over into a 1.4% closing loss on heavy mutual-fund redemptions and margin
calls. The selloff was brutal.

While the SPX was down 12.4% since late May, it had plummeted 10.2% in just
4 trading days straddling last weekend! This wasn't crash-magnitude, which
requires 20% in a couple trading days, but was challenging stock-panic levels
which is 20% over a couple of weeks. The Fed's surreal stock-market levitation
of recent years was finally failing. Real fear was back, with the VIX
soaring to a 40.1 close on Monday.

Although no one could predict such a catastrophic failure of the Fed's SPX
levitation, the odds certainly favored a serious selloff. We were prepared
with SPY puts, bets that the SPX was due for a material drop. We liquidated
some tranches of these Tuesday for average realized gains for our subscribers
of +150%! It pays big to be contrarians when everyone is convinced some manipulated
market trend will run forever.

While such an extreme selloff guaranteed a powerful oversold bounce on short
covering, the critical question is what happens after that? It was the
illusion of central-bank omnipotency, that the Fed can boost stock markets
indefinitely, that pushed the SPX so high in the past couple years. With rate
hikes inexorably nearing, and the stock markets cracking, odds are that blind
faith in the Fed is crumbling.

And that has super-bearish implications. The stock markets are forever cyclical, bears
inevitably follow bulls. This next chart zooms out to show the entire
stock-market bull in SPY terms since early 2009. If a new bear is indeed
looming on the first Fed tightening in over 9 years, the downside from here
remains enormous. Today's central-bank-coddled investors aren't ready to
face the unyielding fury of a real bear.

This amazing cyclical stock bull was righteous and on a normal trajectory
until late 2012, when the Fed launched its wildly-unprecedented open-ended
QE3 campaign. That sparked the decoupling that resulted in the Fed's incredible
stock-market levitation. Virtually everything since 2013 is just a Fed-conjured
illusion, and there's going to be hell to pay as these artificial stock-market
extremes inevitably reverse.

Since it's been a record span since the last correction, today's isn't likely
to prove mild at just over 10%. There are vast amounts of complacency underbrush
to burn, incredible bastions of greed for fear to bleed away. So even if this
exceptionally long-in-the-tooth and outsized stock bull is still miraculously
alive as stock traders desperately hope, a full-blown correction approaching
20% is almost certainly required.

That would drag the SPX back down to levels first seen in mid-2013, wiping
out the past couple years' extraordinary gains. But odds are the selling
won't stop there. Today's stock markets are not only wildly overvalued and
overextended, but today's spoiled-rotten-by-the-Fed traders would likely
freak out with years of gains vaporized. Once a selloff crosses the 20% threshold,
it formally becomes a new bear market.

Bear markets tend to be symmetrical with preceding bulls, the larger the bull
the larger the subsequent bear. And after one of the biggest bull markets in
history thanks to the Fed's gross manipulations, the reckoning isn't going
to be small. Even at a 50% bear over the next couple years, which is merely
average in terms of cyclical-bear size, the damage that would be done to the
stock markets is breathtaking.

A full 50% cyclical bear would drag the SPX all the way back down to levels
first seen in late 2009! That would destroy all vestiges of bullish
stock-market psychology, and drag stock prices back to undervalued levels relative
to trailing earnings. And that's exactly what stock bears exist to accomplish.
Bulls leave the stock markets overvalued and greed extreme, then bears follow
to maul away the resulting excesses.

And contrary to the Fed-inspired myth today that stock bears are rare, they
certainly aren't. While we've yet to see a stock bear this decade, the 2000s
saw no fewer than two! After seeing similar overvalued and overextended stock-market
conditions to this summer's, the SPX suffered a 49.1% bear market over 2.6
years ending in October 2002 and a second 56.8% cyclical bear over 1.4 years
ending in March 2009.

This past week's extreme stock selloff was exceptional. Apparently there've
only been 8 times since 1980 where the S&P 500 has suffered consecutive
3%+ down days! It's hard to imagine such an extreme selloff not severely damaging
traders' faith in central-bank omnipotency. This coupled with the Fed's coming
rate-hike cycle is almost certain to spawn a new bear market given the topping
conditions leading into it.

But the extreme selloff this past week is nothing like bear markets, which
are slow and methodical. A typical bear lasts a couple years, which
encompasses about 500 trading days. To get to a 50% total decline over that
time requires an average daily loss of just 0.1%, nothing. By unfolding slowly,
bears work to trap bulls into staying fully invested for as long as possible
without realizing the grave danger they're in.

And if the overdue next cyclical bear is indeed upon us, it's rarely been
more important to cultivate a studied contrarian perspective on these markets.
That's our specialty at Zeal. We've spent decades studying market cycles, and
understand how to thrive in bears with investments moving counter
to stock markets. Since 2001 including those last two bear markets, all
700 stock trades recommended in our newsletters have averaged annualized realized
gains of +21.3%!

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The bottom line is the Fed's extraordinary stock-market levitation of the
past couple years is failing. The stock markets plummeted this past week after
the Fed offered no clues that it was delaying its upcoming rate-hike cycle
any longer. That selling quickly cascaded, greatly damaging traders' faith
in that myth that central banks can artificially manipulate stock markets higher
indefinitely. This has very bearish implications.

If the Fed can no longer suppress stock-market cycles, the next cyclical bear
market is overdue to charge in with a vengeance. And it's likely to be an exceptionally
large one following such an outsized cyclical bull. Bear markets see average
declines near 50% over a couple years or so, which serve to maul stock prices
back in line with underlying earnings fundamentals. That's going to crush Fed-coddled
stock traders.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
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